Impact of Financial Distress on Stock Returns : Evidence from Emerging Market of Pakistan

Abstract

This study explore the relationship between financial distress and stock returns in equity market of Pakistan for the time period of June 2005 to June 2012 by Fama and French (1992, 1993) three factor model and Macbeth and Fama (1973) technique. This relationship is being explored empirically by adding distress factor HMU in three factor model of Fama and French by employing a sample of 100 firms listed on KSE. Analysis of the results reveals that distress factor is priced in equity market of Pakistan. Size factor, value factor and distress factor are found significantly related to returns of portfolio returns at confidence interval of 95%.Traditional model of asset pricing CAPM is found valid for Pakistani market as factor of market is significantly explain returns of all portfolios. However, four factor model is unable to explain the future returns for stock market of Pakistan as results of second pass regression are substantially insignificant, though it is valid for explaining the current returns of stocks. As distress premium exist in equity market therefore decision makers have to consider these four factor factors, three factors of Fama and French and distress factor in making decisions about investment, financing and evaluation of financial instruments. These results are important, in the sense, that these can facilitate investors in efficient resource allocation.